Private equity

The propaganda versus the facts

MITT ROMNEY has not been kind to the private equity industry. Before he emerged as a presidential contender, the buyout barons were contentedly earning fortunes magnified by quirks in the tax code. Thanks to him, they now are demonized as rapacious asset-strippers who hide their ill-gotten gains in secret bank accounts. Unsurprisingly, the moguls have decided to fight back with a public relations campaign titled “Private Equity at Work”. The propaganda is based on three ideas: PE creates jobs, PE increases productivity, and PE allocations boost the returns of public pension plans. The facts paint a muddier picture.

As it turns out, target-firm employment losses are much greater in public-to-private transactions than other private equity buyouts. Relative to controls, employment shrinks by 10% of initial employment in the first two years after private equity buyouts of publicly traded firms.

The second case is the strongest. The existing literature seems to suggest that, overall, PE ownership improves the productivity of takeover targets. One study looked at the number and quality of patents generated by firms owned by PE funds:

Our main finding is that firms pursue more influential innovations, as measured by patent citations, in the years following private equity investments. Firms display no deterioration in their research, as measured either by patent “originality” or “generality,” and the level of patenting does not appear to change after these transactions. We find some evidence that patent portfolios become more focused in the years after private equity investments. The increase in patent quality is greatest in the patent classes on which the firm has historically been focused and in the classes where the firm increases its patenting activity after the transaction. The patterns are robust to a variety of specifications and controls. Taken together, these findings are largely inconsistent with the hypothesis that private equity–backed firms sacrifice long-run investments. Rather, private equity investments appear to be associated with a beneficial refocusing of firms’ innovative portfolios.

The one robust predictor of LBO leverage we find is the prevailing condition of debt markets: the higher the credit risk premium of leveraged loans, measured as the high-yield spread over LIBOR, the lower the leverage used in the buyout transactions. As a consequence, leverage in the LBO deals is pro-cyclical, with leverage peaking during “hot” credit market conditions, such as in 2006-2007, and falling when debt markets deteriorate, such as in 2008-2009. In contrast to the procyclicality of buyout leverage, we find that a matched set of public firms exhibits countercyclical leverage.

We then examine whether the availability of leverage leads private equity funds to pay higher purchase price multiples for the firms they acquire. We find that this is indeed the case, with buyout pricing being strongly negatively related to current market interest rates on leveraged loans, even after controlling for pricing in public markets. We also show that the impact of debt markets conditions on buyout leverage and pricing holds in a time-series regression, controlling for a large set of macroeconomic variables, and using several alternative measures of debt market conditions…We estimate equations measuring the impact of leverage on fund returns. Contrary to the basic cost of capital prediction that, holding other factors constant, returns to equity should increase with leverage, we document that the leverage of the deals in a particular fund is negatively related to the return of that fund (measured relative to returns on public stock markets), controlling for other relevant factors. This finding is consistent with an agency story in which private equity funds overpay for deals at times when leverage is cheap.

As if all this were not bad enough, PE funds have one extremely undesirable property: their performance is negatively correlated to the amount of money allocated PE funds. Consider this study:

Prices paid for cash flow were generally higher at the end of the buyout waves than at the beginning. The more recent period, in particular, exhibits a great deal of cyclicality, first dipping substantially in the 2001 to 2003 period and then rising afterwards…We use capital committed to private equity funds in the vintage year and the previous vintage year relative to the total value of the U.S. stock market. Regressions 1 to 4 in table 3 indicate a strong negative relation between fundraising and subsequent vintage year returns. The inclusion of a time trend does not affect the results. While this simple regression finding can only be considered illustrative of broader patterns, it suggests that the inflow of capital into private equity funds in a given year can explain realized fund returns during the subsequent ten- to twelve year period when these funds are active. In particular, it strongly suggests that an influx of capital into private equity is associated with lower subsequent returns…Capital commitments are positively and significantly related to lagged private equity returns. I.e., investors seem to follow good returns. Second, the positive trend is consistent with significant secular growth in private equity fund commitments over time above any cyclical factors. To summarize the regressions, private equity fund returns tend to decline when more capital is committed to this asset class. Capital commitments to private equity tend to decline when realized returns decline. In other words, the patterns are consistent with a boom and bust cycle in private equity.

Unfortunately for the pension plans that have allocated money to PE funds, the paper also notes that more than half of all buyout deals since 1970 “had not yet been exited by November 2007.” Their conclusion is sobering:

What will happen to funds and transactions completed in the recent private equity boom of 2005 to mid-2007? It seems plausible that the ultimate returns to private equity funds raised during these years will prove disappointing because firms are unlikely to be able to exit the deals from this time period at valuations as high as the private equity firms paid to buy the firms. It is also plausible that some of the transactions undertaken during the boom were less driven by the potential of operating and governance improvements, and more driven by the availability of debt financing, which also implies that the returns on these deals will be disappointing.

While some of the charges against the private equity industry might be unfair, its practitioners should not defend themselves by pointing to the returns they have supposedly generated on behalf of public pensions.

Job destruction is just as important as job creation. New technology destroys jobs, too. Poor management decisions destroy jobs. Schumpeter called it creative destruction.

BTW, taxes destroy jobs, too.

PE's job is to buy public companies whose stock is cheap because of poor management, rebuild it into a profitable company, then make a good profit by taking it public again.

I saw an interview years ago with a guy whom judges hired to manage bankrupt companies. He said the first thing he did was fire half the accountants.

Often companies launch product lines that fail but management won't give up on them. Sometimes management expands to rapidly with too much debt. To restore failing companies managers need to sell assets to pay down debt and that requires laying off people.

As far as the returns to PE are concerned, large investors like insurance companies are looking for more than the percentage return. They're looking for diversity and lower volatility, which PE offers.

The point of a private equity firm is to make money for the partners in the firm. Everything else is secondary to that. Really. That on the whole they neither benefit nor subtract value means that they are what many suspected, a method to "churn" companies with which to make money for the churners. And as to the pension funds? As PT Barnum said there is one born every minute.

Private equity plays an important role in the economy. No more, and no less.
But then again, plumbers, sanitation workers, accountants, movie stars, nannies, teachers and pretty much everyone also play an important role in the economy.
Anyone who tries to play up how awesome and important they are to the economy is acting like they're in one of those new Dr. Pepper commercials where everyone wear's a red shirt that reads a different variation of "I'm unique!"
We're all important, and no one is really more important than someone else. The economy is the ultimate team sport.

1. PE does not, in and of itself, create change. It merely facilitates change by providing an alternative means of restructuring a company. Whether these changes are for the better or worse is beside the point. PE is merely the catalyst in a chemical reaction.

2. Arguably, these changes would have happened regardless, e.g. US car companies would have declined, but the emergence of the Japanese accelerated it.

A very good point - one that is always overlooked bvy the casual observer of the economy. A more accurate description is that PE disposes of jobs that are already obsolete in order to grow enterprises - their ultimate objective, as job destruction in itself is not the point of wealth creation.

People dislike this, but it is necessary to move people from producing typewriters, slide rules or buggy whips into more productive endeavours.

"The third case is the weakest. Independent studies have repeatedly shown that, overall, PE funds earn returns that are almost exactly comparable to what could be achieved by buying a broad index of small-cap stocks with leverage."

So the shocking truth is that the market will discover equilibria in the long run? If private equity earns higher returns, investors will shift money into it. This continues until PE no longer beats other forms of investments.

"As if all this were not bad enough, PE funds have one extremely undesirable property: their performance is negatively correlated to the amount of money allocated"

If positive correlation is what you desire, I suggest putting all your pension savings into a pyramid scheme. That's the only form of investment I know of that doesn't suffer from the law of diminishing returns.

That jobs are reduced in private to public takeovers vs private to private takeovers doesn't mean PE destroys jobs, only that public companies are less efficiently run. In the extreme, if a PE shop takes over a failing company, injects capital and reduces employment by 20%, did it 'destroy' 20% of the jobs or save 80%?

That capital chases returns is certainly not unique to PE. Certainly public market mutual funds and ETF's follow the same pattern, when recent returns have been best, prices are highest, liquidity is good, and capital flows in. At least in PE all those proceeds aren't deployed immediately, and the manager has the ability to take advantage of changes in market conditions.

For the most part, pension funds and insurance companies aren't looking for huge returns. They're suspicious that firms with high returns are taking too much risk. They're looking for decent returns plus diversity, which will reduce the overall risk/volatility of a portfolio. PE returns have the major advantage of not being correlated with the stock market.

PE doesn't create jobs because PubCos acquired by PE lose jobs. Although on net, employment stays the same. So jobs are created elsewhere. Since (a) PE is so named because it refers to investments in private companies (relatively few PE investment are in PubCos), and (b) acquired PubCos were presumably under performing (or their stock price would be too high to warrant investment), I'm not sure how relevant this is.

PE doesn't boost investor returns, because returns in aggregate are no better than a levered small-cap portfolio. But (a) big pension funds will often have the cream of the crop and invest in top-performing PE firms, and (b) even if returns were equivalent it would be exposing the pensions to different risk and diversifying their portfolio. Still seems like there's benefit there.

Private equity deals are great if you don't hold bad investments and the cycle doesn't turn against you and you aren't late in when prices have risen.

I remember after the crash how we saw two clear things: the illiquidity of private equity investment and the failure of marking values to market of illiquid investments, particularly when those asset values are inflated by an investment boom cycle. So sure private equity can boost returns ... if you're lucky.

That's fair -- but in what manner do you perceive the federal government to have been making commercial decisions for your company rather than your investors?

How much money did your investors make in profit before the company failed?

iow: When the company failed, did the investors lose everything? Or did they saddle the company with debt and then let that debt fail with the company.... walking away scott free with their dividends and management fees skimmed from the company before it failed?

Essentially, my experience with companies is the same as yours, except with VC instead of PE -- and when tech startups fail the VC lose all their money they put in (including any leverage they might have used).

That's not my understanding of PE. They certainly do leverage their investment, but then the company owes for the leverage rather than the investors.

PE firms over the promise of higher returns, which more often than not are not realized. Their modus operandi doesn't scale. There just aren't that many poorly managed yet redeemable companies around. In today's fast moving world, a single misstep could kill a company outright. Competitors would leave it in their dusts.

You can't get fired though for investing in a fund that WAS yielding 15%. If the expected returns fail to materialize, hey, it's the other guy's fault.

This is a great subject to discuss and debate. I won't try to refute anybody's opinion; just state my own. I don't really have a dog in that hunt. I worked for a small company that received a big hunk of PE. We liked it because it would allow us to grow and hopefully make us all more money. The PE firm liked it because it would allow us to grow and make them some money. The California Public Employees Retirement fund, who put up a large chunk of the dough, liked it because it might allow us to grow and make them some money. The city and state liked the idea because it would bring money into the local economy. The Feds liked it because they would get a higher tax rate on the increase in revenue than they would get for idle money. Everybody was happy until our company failed; then nobody was happy. I would still like to have the first three groups making commercial decisions instead of the last one. Such is life.